Strategies to Mitigate Inflation & Rising Prices
In short: While inflation can negatively impact the value of your company, there are strategies that can be taken to combat its effects.
Higher, more volatile inflation generally has negative effects on financial assets and neutral/positive effects on gold, collectibles and real assets. However, the impact of inflation and price changes on individual company values can vary dramatically. Based on investor experiences from the 1970s, commodity companies and businesses with pricing power perform best in inflationary environments. Knowing the impact that inflation can have on the value of your company can help inform a number of business decisions, from purchasing and pricing of products/services to exit strategies and tax planning.
The following, which was developed from a recent article1 written by Aswath Damodaran, Professor of Finance at the Stern School of Business at New York University and Wall Street’s “Dean of Valuation”, describes the effects of inflation on the drivers of value, namely expected cash flows/growth and risk, and discusses the characteristics of companies that fare better during periods of high inflation.
Expected Cash Flows/Growth – What is Rising Inflation’s Effect?
- Pricing power is a function of the size of the total accessible market and market share. Companies that can pass price increases on to their customers are better protected from the effects of high inflation. Non-discretionary products/services that cannot be delayed or substituted have more pricing power. However, companies in competitive businesses have less pricing power than similar companies with less competition. Unfortunately, businesses that face price regulation are at the mercy of governmental or regulatory authority pricing decisions.
- Cost structure is determined by pricing power and cost efficiencies. Businesses that have substantial, inflation-sensitive costs are more exposed to the effects of higher inflation. Companies that have higher cost of goods sold are more negatively affected by inflation than businesses with lower costs of production. Companies with factors that are more exposed to inflation, such as commodities, raw materials and goods costs and skilled labor, are also more negatively affected by inflation.
- Growth/investment efficiency is a measure of how much investment is needed to grow. Companies with longer term, rigid investment options are more negatively affected by inflation. For example, infrastructure and manufacturing businesses generally must invest large amounts of capital for longer periods of time than do service or technology companies. Businesses with more flexibility and time to pull out of or delay investments are better positioned to weather inflationary storms than companies with less flexibility.
Risk – How Does Higher Inflation Factor into Risk?
- Cost of equity is the rate of return required by equity investors. High risk companies are more negatively affected by inflation. Businesses in riskier industries that are more exposed to market/economic fluctuations may see costs of equity increase more than companies in more stable industries. Companies that operate in hazardous countries may also see larger increases in equity risk premiums than companies that operate in more stable markets.
- Cost of debt is the cost of borrowing money, net of certain tax advantages. Businesses that have more default risk are more negatively affected by higher inflation. Companies with higher, more stable earnings may see costs of debt increase less than companies with lower or negative earnings. Furthermore, businesses with more debt may see a larger increase in their costs of debt than otherwise similar companies with less leverage due to inflation’s effects.
- Failure risk is the chance of a disastrous event putting your business at risk. Companies with higher failure risk are abnormally affected by higher inflation. For example, start-up companies with unproven business models have a greater risk of failure than companies with more established business models. Businesses with large amounts of debt are also more likely to fail than otherwise similar companies that have borrowed less.
How Can You Combat Inflation Effecting Your Business’s Value?
Inflation’s effect on the value of your business comes down to the impact it has on expected cash flow/growth and risk. Companies with pricing power on the products/services offered, low cost of goods/input costs and short-term, flexible investments perform better during periods of high inflation. From a risk perspective, companies with large, stable earnings streams and less debt fare better in inflationary environments and will have better purchasing power amid higher prices. As summarized in a recent Nasdaq article2, below are just a few of the ways you can lessen the impact of inflation on your company and its value:
- Increase prices – Survey the marketplace to see if you are underpricing your products/services. Be sure to have employees communicate any price increases with your customers honestly by letting them know the “why” and/or rid excess inventory by running last-chance promotions framed and priced as a sale.
- Improve operations – Consider an expansion strategy or adding products/services to increase profit margins by further leveraging fixed costs. Promote more of your bestselling products in more places digitally and in person to up your sales and start to negotiate pricing for raw materials with vendors. Buy in bulk from suppliers for which you’ve negotiated lower prices in order to increase your profit margins and control your pricing.
- Revisit finances – Use rewards-earning credit cards to gain something back from your business spending. Consider refinancing high or variable interest rate debt to a lower fixed rate to limit the risk of adjustable rates rising in the future. In order to identify the best financial strategies for your business, it’s best to work with outside advisors.
We’re Here to Help
Bennett Thrasher’s Valuation experts are here to help preserve and increase your company’s value and help you succeed as a business leader in uncertain times. To learn more about how we can help you soften inflation’s effects and plan for rising costs, contact Gina Miller or Brett Dixon by emailing email@example.com.
1Damodaran, Aswath. Musings on Markets. 2022, https://aswathdamodaran.blogspot.com/2022/05/a-follow-up-on-inflation-disparate.html. Accessed August 9, 2022.
2Kriss, Randa. 3 Ways to Lessen the Impact of Inflation on Your Small Business. Nasdaq. 2022, https://www.nasdaq.com/articles/3-ways-to-lessen-the-impact-of-inflation-on-your-small-business. Accessed August 9, 2022.